Are You Liable for Your Single-Member LLC?

The whole point of putting structures in place to hold your assets and businesses is to protect you from your business, and vice-versa. But where single-member LLCs (SMLLCs) are concerned, the wall of liability protection isn’t always as thick as we want it to be.

How Thick are the Walls of Your LLC?

Most of the time I think LLCs (limited liability companies) are great business structures. But there are some risks involved in using an LLC when you are the only owner - especially where your LLC is taxed as a disregarded entity.

Back in around 2003 a personal bankruptcy case in Colorado sent shockwaves through the legal and asset protection industry when the court allowed the corporate veil to be pierced. In this case the owner of an LLC had declared bankruptcy and was trying to shield all of his assets held in an LLC from liquidation by the receiver. The receiver objected, pointing out that what the LLC owner was really trying to do was escape the consequences of his bad financial habits, and that it would not be good public policy to allow him to prevail in this case. The judge agreed with the receiver, but did specifically note that if the LLC had had more than one member, the ruling would have gone the other way.

Since that ruling many asset protection planners have advised their clients to not form single-member LLCs. Many entity formation companies offer a service where they will go on record as owning 1% of the LLC (a separate agreement gives the LLC owner voting rights over that 1% and a unilateral buy-back of the 1% interest. Personally, I am not sure if the 1% solution is always called for. I think the facts in the Colorado case were very specific, and if it had been a third party debtor instead of a bankruptcy issue, the court would have looked at things differently. It’s certainly something to talk about with a local attorney if you’re concerned about your situation.

Interestingly, I just came across an interesting tax court case where the owner of an SMLLC was held liable for unpaid employment taxes owed by the LLC. The owner in this case didn’t argue the fact that the LLC hadn’t paid its self-employment taxes, or even the amount (over $66,000!). But he did dispute the authority of the IRS to try and collect the taxes from him personally. The debt was the LLC’s debt, and not his, he argued, therefore the IRS had no right to ask him for that tax money.

Unfortunately for him the tax court disagreed. Self-employment taxes are assessed at a federal level, not a state level. While state law provided liability protection in business dealings it didn’t apply to a taxpayer’s federal tax liability. When the taxpayer elected to have his LLC taxed as a single-member disregarded entity for tax purposes, he accepted the personal liability that went along with that tax classification. The taxpayer was left holding the $66,000 bill.

On the face of it this seems like a tough break for the SMLLC owner … but if you look at it another way it’s an exercise in personal responsibility. SMLLCs report their earnings and expenses on your personal return, so it’s not like you didn’t know the tax liability existed. And, again, allowing SMLLC owners to escape the consequences of their actions (in this case deliberately not paying self-employment tax) doesn’t look to be good public policy.

So what does this mean? Well, if you are using a SMLLC, it means you need to be aware - aware that your personal actions could have an impact on your LLC’s asset protection.